Race to the Top of the Laffer Curve

David Leonhardt of the New York Times has it exactly backward: America’s corporate tax rates are driving economic activity abroad.

In a recent New York Times article, David Leonhardt argues that low, effective corporate taxes on U.S. corporations have generated low corporate tax revenues. In fact, he has it backwards. Corporate tax revenues are low because the U.S. is driving capital and investment abroad, with some of the highest statutory and effective corporate tax rates of countries within the Organization for Economic Cooperation and Development (OECD).

The international tax literature Roger Gordon and James Hines summarize in their 2002 article shows that mobile capital flows from high-tax to low-tax jurisdictions. In any set of competing countries, relative rates of taxation determine investment flows. In other words, America’s high corporate tax rates are driving investments abroad and causing firms to rethink expansion plans in the United States. The loss in revenues, or in effective taxes paid, should not shock us.

Because the confusion surrounding the corporate tax reform debate is due largely to misunderstanding different measures of corporate tax rates and their effect on investment and revenues, it will help to step back and describe each rate in turn.

Confusion surrounding the corporate tax reform debate is due largely to misunderstanding different measures of corporate tax rates and their effect on investment and revenues.

The statutory rate, also known as the headline rate, is what most people think of when they consider the corporate tax rate. The federal government currently imposes a statutory corporate tax rate of 35 percent on U.S. corporations. The combined federal and state statutory rate of 39 percent is second only to Japan in the OECD. With Japan set to lower its statutory rate by 5 percentage points this year, the U.S. rate will soon be the highest in the OECD and one of the highest in the world.

But for investment purposes, the important figure is the effective average tax rate (EATR), or the difference between the pre-tax return and the post-tax return on investment, expressed as a fraction of pre-tax economic profits. More simply, it is the tax liability that a firm may expect to incur as a fraction of pre-tax economic profits. The EATR differs from the statutory rate because it allows for other features of the tax code, such as depreciation allowances or interest rate deductions, which enable firms to ultimately pay less than the statutory rate.

A 1998 paper by Michael Devereux and Rachel Griffith shows that the EATR is the critical tax rate determining where firms locate investment. Countries with high EATRs lose, while capital flows to the low EATR jurisdictions.

While the rest of the world races to cut rates to attract investment, the United States is watching from the sidelines.

Suppose, for example, a corporation plans to build a new plant in Kansas. The plant is expected to generate $100 in profits over its lifetime, and the total amount of allowances and deductions is $50. So for $100 in profits, the corporation is only taxed on $50. With a statutory rate of 39 percent, the tax liability is 39 percent of $50, or $19.50. In this example, the effective average tax rate on the plant’s income would be $19.50 divided by $100, or 19.5 percent. We can see from this example why this rate more clearly reflects tax liability than the statutory rate.

To more fully understand investment decisions, we should also consider the effective marginal tax rate (EMTR). This rate is particularly relevant for scaling projects. Once a firm decides to build a plant, the EMTR will capture the tax liability on the marginal or additional investment, such as adding a machine to the production line. Suppose the machine costs $50. If the firm can deduct 50 percent of this machinery’s cost, and the firm expects a return of $66 over the machinery’s lifetime, then the marginal effective tax rate would be 0.39*($66-$25)/$66, or 24 percent.

My colleague Kevin Hassett and I have used the methodology described in a 1999 paper by Devereux and Griffith for calculating the effective average and effective marginal rates for investments in plants and machinery. Table 1 shows that the United States has the second-highest EATR in the OECD—nearly 10 percentage points higher than the OECD average. The U.S. EMTR is also the fifth-highest among OECD countries, well above the mean.

To check our results, we compared our relative rankings to those the World Bank obtained in a 2009 study using the “book” method to calculate the effective rate. This approach calculates tax liability as a percentage of financial income for a sample company in various jurisdictions. In Table 2, we show the effective rates computed by the World Bank. While the numeric values vary, the United States remains one of the highest effective-tax-rate jurisdictions.

A few papers, such as one by Kevin Markle and Douglas Shackelford, use actual tax liability data on 12,533 companies located in 79 countries over the period 1988-2007 to approximate the effective average and marginal rates. Because they use actual tax and profit data, their approach is the closest to Leonhardt’s.

The advantage of tax liability data is that it can account for all the different types of deductions, allowances, and credits that may be specific to each company or industry. The disadvantage of this approach is that any firm’s actual tax liability may be a function of its specific tax planning strategies. For example, Leonhardt’s article describes how Yahoo used the loss offset provision to lower its tax rate, Southwest Airlines used generous expensing or economic depreciation rules to reduce its taxable income, and GE shifted profits to low-tax countries. Therefore, tax liabilities may be firm-specific rather than country-specific. This makes these liabilities less reflective of the tax rules and the expected post-tax profitability of investment than the effective tax rate measures that we calculated using Devereux and Griffith’s methodology.

Still, Markle and Shackelford find that U.S. firms face the second-highest EATR in the OECD over the period studied, exceeded only by Japan. Further, while EATRs have been falling for the last two decades worldwide, the ordinal rank from high-tax countries to low-tax countries has changed little. Therefore, even accounting for all the tax planning and loopholes and provisions in the U.S. tax code, U.S. firms fare much worse in the global picture than firms than competing countries.

While the rest of the world races to cut rates to attract investment, the United States is watching from the sidelines. We have not cut our top rate since 1993. In order to raise revenues, we need to move to the top of the Laffer Curve. This is the race to the top we need to win.